Quixotic Fed Policy and the Real Estate Cycle
Over the past year U.S. mortgage rates have risen from sub-3% to over 7%. Unsurprisingly the nation’s real estate market is swooning; home sales are plummeting, inventories of new homes for sale are rising sharply and we are already starting to see signs that home prices are falling. Little doubt that most people over the age of 30 are suffering from some level of PTSD, remembering the economic carnage that came after the last collapse of the real estate market in 2007-08.
This real estate cycle and the last have similar roots — they were both created by bad policy on the part of the Federal government. The one bit of good news is that the underlying malfeasance in each cycle was completely different. Last time government policymakers did far too little, while this time it is fair to say they have done vastly too much. Ultimately, this means that this real estate cycle will have a much smaller negative impact on homeowners and thus the broader economy than the last one did.
The real estate cycle that generated the ‘Great Recession’ started with one of the greatest snake oil inventions ever dreamed up by Wall Street: the subprime mortgage-backed security. Regulators, believing in the economic myths of efficient markets and rational investors, sat idly by as trillions of dollars flowed into the housing market without any basic underwriting standards. The U.S. economy was overheated by the flood of bad debt and asset prices rose to unsustainably high levels driving both excessive consumer spending and housing investment. As with all pyramid schemes, this one eventually collapsed in on itself leading to a massive financial market mess, collapsed household net worth, and a recession that took over 8 years to fully recover from.
This time around the issue with regulators is not a lack of action, but rather too much. The Covid pandemic was a tragic human event but was never the existential economic crisis it was made out to be by too many economists and pundits. The result was one of the most preposterous overuses of stimulus ever experienced — in two short years the nation saw an enormous increase in Federal outlays funded by $6.5 trillion in fiscal borrowing. This was, in turn, funded by $5 trillion in new money delivered by the Fed in the form of quantitative easing despite the fact that the pandemic did not create any major financial problems. As a result, all this stimulus went straight into the money supply, and M2 ended up increasing by 50% in two years, faster than we’ve ever seen before.
When the money supply is expanded so dramatically and so quickly there is little mystery as to what happens — economists have studied such episodes since the very beginning of the social science’s existence two centuries ago. At first, because of money illusion, the excess liquidity creates a surge in economic activity—interest rates fall, asset prices rise, and consumer and business spending expand as a result. But inevitably this excess demand turns into inflation, which in turn causes interest rates to rise even as asset prices and spending fall.
And this is exactly what happened to the U.S. economy and why real estate markets find themselves where they are today. The excessive stimulus that began over two years ago caused mortgage rates to fall and household savings rates to increase. These two factors unleashed a massive amount of pent-up demand for homes into the market. Sales took off, tight inventories translated demand into bidding wars, and home prices leapt by over 40% in two years. None of this was sustainable because it was driven by excess money. Now inflation has kicked in, rates are rising, and the housing market is sagging.
But consider the differences between this cycle and the last one. The last cycle was driven by many years of excessive private borrowing, and the use of public stimulus occurred only after everything started to fall apart. This time the public stimulus was ultimately the driver of the housing bubble. It wasn’t private debt, but excessive public borrowing. Thus, the housing market that started to collapse in 2007 was marred by a very high debt-to-equity ratio, high household debt burdens, and an excess supply of housing. Today’s falling market has one of the lowest debt-to-equity ratios ever seen, low overall household debt burdens, and a very tight supply of housing following a decade of slow housing supply prior to the pandemic. Consider that at the start of 2007 U.S. households had $10 trillion in mortgage debt and $14 trillion in housing equity. Today the figures are $12 trillion in debt and $29 trillion in equity. In 2008, the U.S. housing vacancy rate was 2.8%, while in 2021 it was 0.9%.
Perhaps more importantly the last housing collapse occurred along with a collapse in overall consumer demand. They were highly linked during the Great Recession because it was the ease of obtaining mortgage debt that allowed consumers to overspend. This time around consumer demand is not being supported by debt accumulation but by the trillions of dollars in residual cash left over from the stimulus (household cash balances today are $4.6 trillion, compared to $1 trillion in 2018) combined with rapidly rising wages driven by a tight labor market. Hence, the drop in the housing market this time is occurring without a pullback in consumer spending and without the subsequent loss of jobs and income that hurts housing demand even more.
And this brings us back to the Federal Reserve and the current policies being pursued. Oddly, the Fed is acting as if inflation is hurting consumers, when in fact consumer spending is driving inflation. They are trying to stem inflation by jacking up interest rates, which will do little to cool base consumer demand (driven mainly by cash and earnings), and little to hurt homeowners who mostly have long-term fixed rate mortgages.
It is, however, hurting asset markets more than would be the case had the Fed just let inflation burn out on its own. And this is causing even more pain for housing assets. Still, this will not turn into a complete economic rout because the consumer is largely immune to the Fed’s efforts outside of falling asset prices. Yet again the Fed is pursuing the wrong policy and ultimately will do more harm than good.
But this harm is not as bad as the harm that was caused by looking the other way at Wall Street’s transgressions in the last cycle. Home prices may fall over the next year or two, but rental prices for housing will almost assuredly continue to increase at the same time given strong consumer demand. If we had to sum it up, the housing market of 2009 had too few buyers. The housing market of 2023 will be marked by too few sellers. The net result will be almost no foreclosures, limited price declines, and little in the way of household financial problems created the last time around. But it will be a very cold market for a while… at least until we get used to higher interest rates and begin to realize that not every negative shock is an existential crisis.
As my parents used to tell me in my teenage periods of angst: We are in danger of imminent survival.
Slow Growth Forecasted for California’s Major Metros…But No Recession; Consumer Spending Expected to Keep Local Economies Humming
Modest Price Declines Expected In State’s Famously Expensive Housing Markets
California’s major metropolitan regions will weather any national headwinds caused by the recent banking crisis and are all expected to see employment grow and consumer spending continue for the rest of the year, according to new regional outlooks released today by Beacon Economics. Almost without exception, consumer and business sales tax receipts have grown significantly compared to pre-pandemic levels in the state’s largest urban areas.
“We expect consumer and business spending to carry the day in the near term for these local economies,” said Taner Osman, Research Manager at Beacon Economics and one of the outlook authors. “Despite bearish headlines about bank runs and tech industry layoffs, spending continues to trend above pre-pandemic levels in California’s metro areas.”
Since the 1st quarter of 2020, sales tax receipts have jumped in San Diego (+32.3%), the South Bay (+29% in San Benito County, +17.6% in Santa Clara County), the East Bay (+26.1% in Alameda County, 23.6% in Contra Costa County), and Los Angeles (+25.1%). Statewide, receipts have increased nearly 30%. Only San Francisco has seen a decline (-1.5%) in its business and consumer spending, albeit a minimal one. The new outlooks note that the fall off in San Francisco aligns with weak tourism and air travel data, which indicate that passenger counts through San Francisco International are down nearly 30% from pre-pandemic levels.
The ongoing spending spree across the state’s metros is being driven and bolstered by steady gains in payrolls, according to the new outlook. Indeed, in each of the five regions analyzed, the local unemployment rate has fallen back to a low pre-pandemic level and employment is inching towards an all-time high. Moreover, the forecast has job growth increasing by between 1% and 2.5% in all five metros throughout the remainder of 2023. “Overall, we’re expecting to see slow but steady employment growth across the state’s metros this year… and no recession,” said Osman.
In other findings, the new outlooks are forecasting only modest price declines in the housing markets of California’s major metropolitan areas over the rest of this year. While rising interest rates have taken a toll on the local markets, making mortgages more expensive and sidelining would-be homeowners, there has been little relief in terms of badly needed housing production. “The extremely limited inventory of homes for sale restricts how much prices will fall, with some areas only seeing a deceleration in price growth, not actual drops,” said Osman.
As of February 2023, on an annual basis, only in exorbitantly high-priced San Francisco did the median home price fall markedly, by 10.7%. In the other Bay Area metros, price decreases were more moderate, including a 3.5% decrease in the East Bay and a 0.3% and 5% decrease in the two counties of the South Bay. In Los Angeles and San Diego, price growth decelerated but prices continued to rise year-over-year (+1.8% in San Diego, +0.8% in Los Angeles).
This edition of The Regional Outlook was authored by Osman and Senior Research Associate Justin Niakamal.
View full outlooks for the East Bay, Los Angeles, San Diego, San Francisco, and South Bay.
Banking & Financial Services
All Eyes On The Fed… But Will It Change The US Forecast?
Federal Reserve Policies At The Root Of Recent Bank Collapses; California: A Better Recovery Than We Thought!
The recession forecasted by so many still hasn’t shown up and is looking less and less likely to anytime soon, according to Beacon Economics‘ latest outlook for the United States and California. Moreover, the recent bank failures that have been capturing headlines are being ‘wrongly viewed’ as heralding a coming downturn, something that misses the actual drivers behind the collapses and that key economic data refutes.
“These bank failures are not a reflection of an unhealthy U.S. economy, they are all about Federal Reserve policy,” said Christopher Thornberg, Founding Partner of Beacon Economics and one of the forecast authors. “Sad by true; the body that is supposed to be the wise shepherd of the nation’s banking system is largely responsible for creating the very stressors that caused Silicon Valley Bank to fail, and the run on others to begin.”
According to the outlook, the U.S. banking system, overall, is the victim of quixotic and rapid changes in Fed policy over the last three years as they have tried to maintain both full employment and price stability – which can be mutually exclusive. “In their existential panic over full employment during the pandemic, the Fed destabilized prices by injecting historic amounts of cash into the economy; in their existential panic over price instability, they destabilized the banking system through interest rate increases,” said Thornberg.
The new outlook acknowledges that the sudden crosscurrents from the bank failures have made the forecast fuzzier because stress in the banking system will eventually show up in the broader economy in the form of tightening credit. However, the new forecast does not believe those stressors, on their own, will rise to the level of a recession. “Cash is still king in the U.S. economy,” said Thornberg. “But if the Fed decides to continue raising interest rates in its quest to slow inflation, it will do more damage to the bank credit industry and that will trigger negative consequences for the overall economy.”
Assuming the Fed slows their roll, which they’ve shown some signs of doing, Beacon Economics is expecting slow growth and no recession in the near-term future. The forecast has real U.S. GDP growth in the first quarter coming in between 1% and 2%, although the margin of error has increased given the policy uncertainty.
In terms of the macro economy, the new outlook points to copious evidence of its health: unemployment in the nation remains rock bottom, consumer spending continues despite inflation, earnings growth is still running above 6% for the median worker, U.S. household net worth remains 30% ($30 trillion) higher than it was pre-pandemic, banks are not experiencing an increase in problem loans, and interest rates have started to stabilize causing asset markets to do the same.
In California, the news grew rosier this month after the state released its annual employment revisions, although a declining workforce continues to hamper economic growth. The revision shows that California recovered more and faster from the pandemic’s job losses than previously estimated: There are 197,000 more people employed in the state today than there were pre-pandemic. The original estimates had the gain at a mere 70,000.
However, in terms of the percentage increase, California’s job growth has been about five times slower than states such as Florida and Texas. “The underperformance we’ve seen is certainly not due to any unwillingness on the part of the state’s employers to hire workers,” said Taner Osman, Research Manager at Beacon Economics and one of the forecast authors. “Rather, California’s labor force contracted during the pandemic and there are well over 300,000 fewer workers in the state today than there were before COVID hit; there are simply not enough workers to fill the number of job openings.”
Deeply linked to its declining workforce is California’s famously expensive housing market, where prices surged an astounding 41% during the early days of the pandemic. Today, higher interest rates have led to a collapse in demand and home sales have returned to their pre-pandemic trough. However, home prices remain 27% above where they were pre-pandemic and the new forecast only expects them to fall by 6.3% in 2023. “Given California’s acute long-term housing shortage, it’s not surprising that price drops will be limited,” said Osman. “And this isn’t anything like the Great Recession because consumer balance sheets are so much stronger today and unemployment rates are at all-time lows.”
Career & Workplace
Annual Employment Revision Changes Our Understanding of California’s Recovery From the Pandemic
State Recovery Has NOT Lagged The Nation; California Recovered More And Faster Than Originally Estimated
The annual benchmark revision released today by the California EDD has significantly changed our understanding of California’s recovery from the pandemic, according to an analysis by Beacon Economics. While employment figures from 2022 were revised downwards, 2021’s figures were revised upwards, and in total, the state added far more jobs than originally estimated.
“The revisions have painted a rosier picture of California’s labor market recovery than previous estimates suggested,” said Taner Osman, Research Manager at Beacon Economics. “Importantly, given the contraction in the state’s labor force since the start of the pandemic, the job growth that has occurred is partly due to an expansion in labor force participation.”
Overall, employment growth in the state from December 2021 to December 2022 was revised from 3.6% down to 3.1%, while growth from December 2020 to December 2021 was revised from 6.5% up to 7.7%.
Previous estimates suggested that California had only added 70,000 jobs compared to its pre-pandemic level, while the revisions reveal the state has actually added 197,000 jobs. This means that payrolls as of December 2022 are 1.1% above their pre-pandemic peak, compared to the 0.4% originally estimated. While previous estimates showed the recovery in California as lagging the nation overall, today’s revisions reveal that the state has recovered at roughly the same pace.
The revisions also mean that California recovered the nearly 2.8 million jobs it lost due to the pandemic in June 2022, rather than October 2022, as originally estimated.
Growth in the state’s 2022 labor force was also revised downwards significantly. From December 2021 to December 2022, only 128,700 workers joined the labor force in California, far fewer than the 276,800 originally estimated. This translates into a 2022 labor force growth rate of 0.7% rather than the original estimate of 1.5%. However, at the same time, 2021’s labor force growth rate (from December 2020 to December 2021) was revised from 1.5% up to 2.2%.
At the industry level, the annual benchmark revision was mixed, with growth rates in some sectors were revised upwards, while others were revised downwards. The biggest upward revisions to year-over-year growth rates (December 2021 to December 2022) were in Mining and Logging (revised from 0% to 3.6%), Real Estate (revised from 2.8% to 3.2%), Health Care (revised from 4.7% to 5.0%), and Professional, Scientific, and Technical Services (revised from 4.1% to 4.2%).
The biggest downward revisions in year-over-year growth rates were in Finance and Insurance (revised from 1.0% to -0.9%), Construction (revised from 4.6% to 2.7%), Government (revised from 1.8% to 0.4%), Transportation, Warehousing, and Utilities (revised from 3.8% to 2.9%), Wholesale Trade (revised from 2.2% to 1.3%), Education (revised from 7.0% to 6.4%), Retail Trade (revised from 0.8% to 0.2%), and Leisure and Hospitality (revised from 7.7% to 7.2%).
California’s annual benchmark revision was also mixed at the regional level, with growth rates revised up in some areas and down in others. The largest upward revisions in year-over-year growth rates were in Yuba (revised from -0.6% to 4.1%), Napa (revised from 1.8% to 5.8%), El Centro (revised from 1.8% to 4.9%), Madera (revised from 2.4 to 4.6%), San Rafael (MD) (revised from -1.0% to 1.1%), and Modesto (revised from 0.9% to 3.1%). Downward revisions occurred in Santa Barbara (revised from 4.0% to 1.0%), the Inland Empire (revised from 4.9% to 2.7%), Ventura (revised from 4.1% to 1.9%), Merced (revised from 3.3% to 1.7%), San Francisco (MD) (revised from 5.3% to 3.8%), and Chico (revised from 2.6% to 1.6%).
California’s labor market expanded in January, with total nonfarm employment in the state growing by 96,700 positions over the month. “Despite all the headline gloom about the state of the economy at present, California’s economy added more jobs in January than it has in any month since February 2021,” said Osman.
As of January 2023, California has recovered all of the jobs that were lost in March and April 2020, and there are now 293,900 more people employed in the state compared to February 2020. Total nonfarm employment has grown 1.7% over this time compared to a 1.8% increase nationally. California also increased payrolls by 3.5% from January 2022 to January 2023, outpacing the 3.3% increase nationally over the same period.
California’s unemployment rate increased by 0.1 percentage point, to 4.2% in January 2023. While this rate is near historic lows, it remains elevated relative to the 3.4% unemployment rate in the United States overall. California is continuing to struggle with its lack of labor supply, although the workforce did grow by 44,700 in January. Since February 2020, the state’s labor force has fallen by 283,600 workers, a 1.4% decline.
- While employment levels in nearly half of the sectors in California now exceed their pre-pandemic peaks, employment levels in the hardest hit sectors remain below their pre-pandemic levels.
- The Government sector led gains in January, with payrolls expanding by 46,000. However, Government payrolls are still 2.3% below their pre-pandemic peak.
- Other sectors posting strong gains during the month were Leisure and Hospitality (20,800), Retail Trade (10,200), Health Care (9,600), Professional, Scientific, and Technical Services (9,400), Transportation, Warehousing, and Utilities (6,700), and Wholesale Trade (3,000).
- Payrolls decreased in a handful of sectors in January. Construction posted the largest decline, where payrolls fell by 7,300. However, the decline in Construction payrolls was largely weather related. Other sectors with significant job losses were Information (-5,000), Real Estate (-4,600), and Administrative Support (-700).
- Regionally, job gains were led by Southern California. Los Angeles (MD) experienced the largest increase, where payrolls grew by 37,300 (0.8%) during the month. San Diego (8,700 or 0.6%), Orange County (5,300 or 0.3%), and the Inland Empire (5,300 or 0.3%) also saw their payrolls jump during the month. Over the past year, El Centro (4.4%) saw the fastest job growth in the region, followed by San Diego (4.2%), Orange County (3.5%), Los Angeles (MD) (3.4%), the Inland Empire (2.8%), and Ventura (1.6%).
- In the Bay Area, the San Francisco (MD) experienced the largest increase, with payrolls expanding by 8,900 (0.7%) positions in January. The East Bay (7,900 or 0.7%), San Jose (5,100 or 0.4%), Santa Rosa (1,100 or 0.5%), Napa (300 or 0.4%), and Vallejo (100 or 0.1%) also saw payrolls expand during the month. Over the past 12 months, Napa (5.5%) saw the fastest job growth in the region, followed by San Francisco (MD) (4.3%), San Jose (4.2%), Santa Rosa (3.6%), Vallejo (2.5%), and the East Bay (2.1%).
- In the Central Valley, Sacramento experienced the largest monthly increase as payrolls expanded by 3,900 (0.4%) positions in January. Payrolls in Merced (1,000 or 1.4%), Chico (500 or 0.6%), Fresno (500 or 0.1%), Modesto (500 or 0.3%), Stockton (400 or 0.1%), and Madera (200 or 0.5%) increased as well. Over the past year, Madera (4.5%) saw the fastest growth, followed by Yuba (4.3%), Hanford (4.2%), Fresno (4.0%), Visalia (3.6%), Stockton (3.4%), and Sacramento (3.0%).
- On California’s Central Coast, Santa Barbara added the largest number of jobs, with payrolls increasing by 2,200 (1.1%) during the month. Salinas (900 or 0.6%) and Santa Cruz (600 or 0.6%) saw payrolls decline during the month. From January 2022 to January 2023, San Luis Obispo (3.1%) added jobs at the fastest rate, followed by Santa Cruz (2.9%), Salinas (2.5%), and Santa Barbara (2.3%).
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